The responsibility of investment decision is assigned on financial managers. Therefore, they are responsible for a company’s investment decision, advising on the allocation of funds in terms of the total amount of assets, the composition of fixed and current assets and the consequent risk profile of the choices. According to Myers (1974) the problem however, lies on the determination of which set of current and planned future transactions will maximize the shareholders' wealth. This can be employed by, firstly, specifying the firm's objective as a function of investment and financing decisions and secondly, capturing interactions of the financing and investment opportunities by a series of constraints (Myers, 1974).
When evaluating capital budgeting projects, it is important to be able to compare alternatives using an objective yardstick, regardless of the pattern of the cashflows that result from each alternative. However, net present value (NPV) is generally agreed to be the preferred model for evaluating projects (Watson and Head, 2004 ; Myers, 1974 ). There are other alternative techniques such as the accounting rate of return and the payback / discounted payback methodology. Although not as theoretically sound as NPV, these models nonetheless are still widely-used today, often in conjunction with NPV analysis.
According to finance theory, investment opportunity should be taken as if it already had plenty of cash on hand. In an efficient capital market however, securities can always be sold at a fair price because the net present value of selling securities is always zero. The cash raised exactly balances the present value of the liability created. Therefore, the decision rule is: take every positive-NPV project, regardless of whether internal or external funds are used to pay for it (Myers and Majluf,1984).
Additionally, the reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents. On the other hand, investing solely in cash investments may be appropriate for short-term financial goals. The principal concern for individuals investing in cash equivalents is inflation risk, which is the risk that inflation will outpace and erode returns over time.
According to the Department of Trade and Industry (DTI) (2006) the search theory can provide a useful framework for analysis of decision making in circumstances where there is uncertainty about the potential costs and benefits of alternative actions. As a result, the search theory can reduce uncertainty and improve decision making. It is important to remember that investment has important effects on both the demand-side and the supply-side of the economy (Pike and Neale, 2009). On the other hand, The central message of economic theory and the evidence from business surveys is that capital investment is determined by the relationship between the expected returns from investment and the expected cost of financing the investment.
Moreover, the analysis of business decisions about overseas market prioritisation and market-entry strategy can be done in terms of search Models (DTI, 2006). Watson and Head (2004) However, highlighted that decision makers can be expected to continue to lack perfect information, and to make some poorly informed decisions, nevertheless having acquired the economically efficient level of information (DTI, 2006) The costs of failure resulting from poorly informed decisions may still be lower than the real resource costs of acquiring additional information (DTI, 2006).
The “options” pricing theory is concern about the understanding of investment behaviour when decision makers face uncertainty about future prices and returns and when their decisions are irreversible (Carruth, et al. 1998). The key insight is that the “option” value will the investment decision in order to wait the arrival of new information about market conditions (Carruth, et al. 1998). As a result, a wedge will be created between the conventional net present value (NPV) calculation of the current worth of an investment project and the current worth of the project to the decision maker. At a given point in time, for an investment to be made, its NPV must be sufficiently larger than zero to cover the value to the decision maker of delaying the decision and keeping the investment option alive.
Therefore, uncertainty will influence the timing, and hence on the level of investment activity at a given point in time for a particular level of uncertainty prevailing among investors. Moreover, it also points to the possibility of threshold effects, that is, rates of return below which investment will not be undertaken. There are also macroeconomic consequences since such effects can generate real rigidities in the capital accumulation process (Pike and Neale, 2009).
In contrast the work of Hartman (1972) and Abel (1983) suggested that increased uncertainty may raise investment, because of its positive effect on the value of a marginal unit of capital. This result requires that the marginal product of capital (in a competitive firm) is ‘convex in price’ , so that a mean-preserving increase in the variance of price raises the expected return on a marginal unit of capital and therefore raises the attractiveness of investment.
According to Bank of England (2009) there are different of key factors driving capital investment spending. For example, interest rates, expectations and confidence, profits and external economic factors.
Reference
Abel, A. B. (1983) ‘Optimal investment under uncertainty’, American Economic Review, 73, pp.228-33.
Bank of England
Deparment of Trade and Investment (2006) ‘Rational for Government Support’, International Trade Investment paper No. 18
Hartman, R. (1972) ‘The effects of price and cost uncertainty on investment’, Journal of Economic Theory, 5, pp. 258-66.
Myers, S. C. (1974) Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting’, The Journal of Finance, 29(1), pp. 1-25.
Journal of Financial Economics 13, pp.187-221.
Pike, R. and Neale, B. (2009) Corporate Finance and Investment: Decisions and Strategies. 6th edition. Essex : Pearson Education Limited
Watson, D. and Head, A. (2004) Coporate Finance: Principles and Practice. 3rd edition. England
Carruth, A. Dickerson.A. and Henley , A ( 1998) ‘What do we know about investment under uncertainty?’,
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